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India's banking system liquidity is expected to remain in deficit in the second half of 2022-23 as credit growth has picked up and the volume of banknotes in circulation has increased, believe analysts. 

The country's banking liquidity slipped into deficit on Tuesday for the first time in nearly 40 months, the central bank said.

The central bank has infused 21,800 crore into banking system on Tuesday, the biggest since May 2019. Overnight rates continue to stay elevated, with one-day call money rate jumping to 5.85%, highest since July 2019.

Meanwhile, the RBI will conduct an overnight variable rate repo auction for 50,000 crore on Thursday.

"On a review of current liquidity conditions, the Reserve Bank of India has decided to conduct a Variable Rate Repo auction on September 22," RBI said in a statement.

"The onset of the festive season and expectation of sequential improvement in economic growth would increase transactional demand for cash," Vivek Kumar, an economist with QuantEco Research, was quoted as saying by Reuters.

As a result, currency in circulation could jump by 2.2-2.4 lakh crore in the second half of this fiscal, Kumar estimated.

Meanwhile, government spending, which boosts liquidity in the market, has been slower than expected despite robust tax collections.

"This combination of slow pick-up in government expenditure and buoyant tax collection is reflected in government cash balance," said Gaura Sen Gupta, an economist with IDFC First Bank.

Widening liquidity deficit

A widening liquidity deficit could lead to a rise in short-term borrowing rates and prompt the RBI to pump in money into the banking system and slow down its interventions in the currency market.

The year 2022-23 started with a liquidity surplus of over 8 lakh crore in early April. The central bank had said at the time that withdrawal of liquidity would be a "multi-year" process.

As of yesterday, the systemic deficit stood at 21,800 crore, its highest since May 2019, with tax outflows in past week also squeezing liquidity.

According to QuantEco's Kumar, core systemic liquidity surplus, which also includes the government's cash balance, had reached a peak of 12 lakh crore in September last year but has since sharply declined to 3.9 lakh crore.

Over half of this drawdown is on account of the RBI's dollar sales to cushion the rupee's fall, he estimated.

A negative balance of payment has weighed on overall liquidity.

India's balance of payment was in a deficit of $16 billion as of March this year, with analysts expecting the gap to widen further in the next few quarters. A large deficit forces the central bank to sell dollars into the market, sucking out rupee liquidity.

The RBI has sold a net of around $39 billion from its foreign exchange reserves between January and July, with reserves shrinking to a two-year low of $551 billion as of 9 September, data showed.

"Unless we see reasonable improvement in the balance of payment deficit, liquidity tightness will continue to persist," said Soumyajit Niyogi, director at India Ratings.

RBI ACTION

The U-turn in liquidity has pushed up the overnight inter-bank rate above the policy repo rate of 5.4%.

"In the past, the RBI has announced term repo auctions to alleviate liquidity pressures when the weighted average call rate has exceeded the repo rate for a few days," IDFC First Bank's Sen Gupta said.

The RBI has stopped purchasing government bonds since October 2021 and analysts do not see the central bank returning any time soon.

The central bank could reactivate fixed and variable rate repo windows, QuantEco's Kumar added.

"With monetary policy in tightening mode, the likelihood of RBI conducting OMO (open market operation) bond purchases to augment liquidity is low," Kumar further said.

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